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Not All Deductions Are Created Equal
Tax and Financial News
May 2004
Not All Deductions Are Created Equal
We in the United States of America live in a country where individual liberties and the notion of the basic equality of all persons are jealously guarded. In America, just about anyone can go from poverty to riches if they have the talent and fortitude to do what it takes to achieve their dreams.
But even in America, the basic notion that all persons are created equal is not precisely true. While it is true that no person's liberties should be abridged and everyone deserves to be treated equally under the law, we don't all have the same talents and some talents are perceived as less valuable than others. That doesn't make any person less valuable than another, but society pays some occupations more than others. For example, a normal working CPA will never earn from his or her profession as much in a lifetime as Michael Jordan makes in one year.
The same is true of income tax deductions. For one reason or another, Congress did not view some deductions worth as much as others. That's what we would like to discuss with you this month.
As we all know, there are some expenses that are deductible as business expenses and still others that are personal in nature, but are still deductible. While some of these can be deducted on the first page of Form 1040, we will discuss those that are listed on Schedule A to Form 1040.
Medical Expenses
What constitutes medical expenses? Can you deduct the aspirin you purchase at the local drugstore or the bandages with Elmo's picture on them your two-year-old seems to go through like water? Sorry, but the government had to draw a line in the sand and that line basically is the term "medically necessary." While this can be difficult to define, the reality is that one must act as directed by a doctor or pay for the health professional's in order to be deductible.
Given the need to include a healthcare professional in the mix, some of the more common expenses are doctor's fees, mental health counselor's fees, fees for laboratory expenses and prescription medicine. The word "prescription" basically takes out over-the-counter medications and supplies, but it can help in other areas.
For example, remodeling a bathroom to meet the medical needs of a person in a wheelchair can be deductible to some extent, but your doctor should prescribe the remodeling job be done. In some cases, swimming pools for persons with certain diseases may be deductible to some extent as well as other home improvements.
Do you pay health insurance? If it is not deductible elsewhere, the insurance premiums may be deductible on Schedule A. This assumes the premium is not tied to a cafeteria plan and is paid for in after tax dollars. With the cost of health insurance these days, this can be a significant deduction. Don't forget long-term care insurance either. Though it is not fully deductible, there is some level of deduction for long-term care insurance.
There are other deductible expenses such as mileage driven for medical reasons, eyeglasses and other assistive devices, hospital costs and nursing home costs. If you have a sitter that helps you perform daily living tasks, their cost, including related payroll tax, is deductible.
This discussion could go on forever, but there is something you absolutely must know. In order to be deductible, medical expenses must exceed 7.5% of adjusted gross income. This can be a big number. For example, if your adjusted gross income on Form 1040 is $50,000, the first $3,750 in expenses will result in no deduction. The point is that if you are looking at significant costs over a period of time, the more cost you can bunch into one year, the more likely you are to benefit from medical expenses as itemized deductions.
Taxes
State income taxes that you pay are generally deductible expenses. In some instances, these can be relatively steep. Include real property tax and personal property taxes based on the value of the personal property, and you can have a pretty healthy itemized deduction. The good news is there is not a percentage floor for these deductions like there is for medical expenses.
By the way, don't even think about trying to deduct sales taxes. That deduction has been gone a long time.
Interest
Do you own your home? Or does the mortgage company own it and you pay a monthly note? Assuming you are paying a house note, the interest paid on that loan is deductible in full up to a point. If you borrowed $1 million to buy the house you are in, you're ok, but interest on debt over $1 million is not deductible. Interest on home equity loans is deductible also. Be careful, though, you may be limited to interest only on the first $100,000.
Points paid for acquiring a loan to buy a house are deductible as are other fees based on a percentage of the loan. If you refinance, you will only be able to deduct the expense ratably over the life of the new loan.
Do you borrow money to make stock or other investments? Investment interest is generally deductible to the extent of investment income. This would include dividends, interest and, to some extent, capital gains.
Charitable Contributions
Charitable contributions come in many forms and can save a bundle in taxes. There are, however certain limitations. The easiest donations to categorize are cash donations. Generally, you can deduct 100% of these contributions up to 50% or your income. Non-cash donations follow the same general rule, but there is additional documentation required when the value of the donation goes over $500 and $5,000.
What gets a bit trickier is when capital gain property is donated. Say you give a thousand acres of timber that cost you $25,000 and it is worth $2.5 million when donated. You get a $2.5 million deduction, but you are limited to a deduction of only 30% of your adjusted gross income. Sure you can carry the excess forward 5 years, but you may never get the full deduction. Likewise, a donation to a private foundation is similarly limited to 30% of adjusted gross income.
Gambling Losses
If you hit a jackpot and won $50,000 at the casino this year, but you lost the same amount the rest of the year, do you have to pay tax on the $50,000? To some extent, the answer is yes. The answer is yes because that $50,000 in winnings is included in adjusted gross income, while the losses are deducted as itemized deductions. The problem is that the increased adjusted gross income goes into all the calculations like the 7.5% medical floor and similar items. This, in turn, can cause the value of other itemized deductions to decrease.
Casualty Losses
Casualty losses like natural disasters, theft losses and similar losses are deductible to the extent they exceed 10% of adjusted gross income plus $100. Any losses must be offset by insurance and other reimbursements.
Miscellaneous Itemized Deductions
There is a class of deduction that is limited to 2% of adjusted gross income. These include employee business expenses, investment expenses, tax preparation and advice expenses, etc. In many cases, this all but makes these deductions worthless. Still, they are worth including on Schedule A in the event the collective amount exceeds the 2% floor.
Conclusion
It is reasonably easy to see from this short discussion that different itemized deductions are governed by different rules. Some are fully deductible while others are severely limited. We haven't even discussed the phase-out that starts when certain income levels are reached. Now, more than ever, planning amounts and timing of deductions is critical. If you think you may have missed a deduction or simply want to explore deduction planning for the future, give us a call. We are here to help and always available to discuss your needs.
Have a great May and please keep our troops in your thoughts and prayers.
But even in America, the basic notion that all persons are created equal is not precisely true. While it is true that no person's liberties should be abridged and everyone deserves to be treated equally under the law, we don't all have the same talents and some talents are perceived as less valuable than others. That doesn't make any person less valuable than another, but society pays some occupations more than others. For example, a normal working CPA will never earn from his or her profession as much in a lifetime as Michael Jordan makes in one year.
The same is true of income tax deductions. For one reason or another, Congress did not view some deductions worth as much as others. That's what we would like to discuss with you this month.
As we all know, there are some expenses that are deductible as business expenses and still others that are personal in nature, but are still deductible. While some of these can be deducted on the first page of Form 1040, we will discuss those that are listed on Schedule A to Form 1040.
Medical Expenses
What constitutes medical expenses? Can you deduct the aspirin you purchase at the local drugstore or the bandages with Elmo's picture on them your two-year-old seems to go through like water? Sorry, but the government had to draw a line in the sand and that line basically is the term "medically necessary." While this can be difficult to define, the reality is that one must act as directed by a doctor or pay for the health professional's in order to be deductible.
Given the need to include a healthcare professional in the mix, some of the more common expenses are doctor's fees, mental health counselor's fees, fees for laboratory expenses and prescription medicine. The word "prescription" basically takes out over-the-counter medications and supplies, but it can help in other areas.
For example, remodeling a bathroom to meet the medical needs of a person in a wheelchair can be deductible to some extent, but your doctor should prescribe the remodeling job be done. In some cases, swimming pools for persons with certain diseases may be deductible to some extent as well as other home improvements.
Do you pay health insurance? If it is not deductible elsewhere, the insurance premiums may be deductible on Schedule A. This assumes the premium is not tied to a cafeteria plan and is paid for in after tax dollars. With the cost of health insurance these days, this can be a significant deduction. Don't forget long-term care insurance either. Though it is not fully deductible, there is some level of deduction for long-term care insurance.
There are other deductible expenses such as mileage driven for medical reasons, eyeglasses and other assistive devices, hospital costs and nursing home costs. If you have a sitter that helps you perform daily living tasks, their cost, including related payroll tax, is deductible.
This discussion could go on forever, but there is something you absolutely must know. In order to be deductible, medical expenses must exceed 7.5% of adjusted gross income. This can be a big number. For example, if your adjusted gross income on Form 1040 is $50,000, the first $3,750 in expenses will result in no deduction. The point is that if you are looking at significant costs over a period of time, the more cost you can bunch into one year, the more likely you are to benefit from medical expenses as itemized deductions.
Taxes
State income taxes that you pay are generally deductible expenses. In some instances, these can be relatively steep. Include real property tax and personal property taxes based on the value of the personal property, and you can have a pretty healthy itemized deduction. The good news is there is not a percentage floor for these deductions like there is for medical expenses.
By the way, don't even think about trying to deduct sales taxes. That deduction has been gone a long time.
Interest
Do you own your home? Or does the mortgage company own it and you pay a monthly note? Assuming you are paying a house note, the interest paid on that loan is deductible in full up to a point. If you borrowed $1 million to buy the house you are in, you're ok, but interest on debt over $1 million is not deductible. Interest on home equity loans is deductible also. Be careful, though, you may be limited to interest only on the first $100,000.
Points paid for acquiring a loan to buy a house are deductible as are other fees based on a percentage of the loan. If you refinance, you will only be able to deduct the expense ratably over the life of the new loan.
Do you borrow money to make stock or other investments? Investment interest is generally deductible to the extent of investment income. This would include dividends, interest and, to some extent, capital gains.
Charitable Contributions
Charitable contributions come in many forms and can save a bundle in taxes. There are, however certain limitations. The easiest donations to categorize are cash donations. Generally, you can deduct 100% of these contributions up to 50% or your income. Non-cash donations follow the same general rule, but there is additional documentation required when the value of the donation goes over $500 and $5,000.
What gets a bit trickier is when capital gain property is donated. Say you give a thousand acres of timber that cost you $25,000 and it is worth $2.5 million when donated. You get a $2.5 million deduction, but you are limited to a deduction of only 30% of your adjusted gross income. Sure you can carry the excess forward 5 years, but you may never get the full deduction. Likewise, a donation to a private foundation is similarly limited to 30% of adjusted gross income.
Gambling Losses
If you hit a jackpot and won $50,000 at the casino this year, but you lost the same amount the rest of the year, do you have to pay tax on the $50,000? To some extent, the answer is yes. The answer is yes because that $50,000 in winnings is included in adjusted gross income, while the losses are deducted as itemized deductions. The problem is that the increased adjusted gross income goes into all the calculations like the 7.5% medical floor and similar items. This, in turn, can cause the value of other itemized deductions to decrease.
Casualty Losses
Casualty losses like natural disasters, theft losses and similar losses are deductible to the extent they exceed 10% of adjusted gross income plus $100. Any losses must be offset by insurance and other reimbursements.
Miscellaneous Itemized Deductions
There is a class of deduction that is limited to 2% of adjusted gross income. These include employee business expenses, investment expenses, tax preparation and advice expenses, etc. In many cases, this all but makes these deductions worthless. Still, they are worth including on Schedule A in the event the collective amount exceeds the 2% floor.
Conclusion
It is reasonably easy to see from this short discussion that different itemized deductions are governed by different rules. Some are fully deductible while others are severely limited. We haven't even discussed the phase-out that starts when certain income levels are reached. Now, more than ever, planning amounts and timing of deductions is critical. If you think you may have missed a deduction or simply want to explore deduction planning for the future, give us a call. We are here to help and always available to discuss your needs.
Have a great May and please keep our troops in your thoughts and prayers.
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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